The value of the 100 leading shares on the London market fell by £49bn, extending the two day loss since the publication of poor American jobs figures last Friday to £82bn.

By the close of business in the City, the FTSE 100 index was down 189.45 points at 5102.58, a decline of 3.5%. Markets elsewhere in Europe suffered even bigger falls, with Germany's Dax index of leading shares shedding more than 5%. France and Italy also saw share price falls of around 5%.

Dealers said investors had been unsettled by reports of a rift between Athens and the International Monetary Fund over the terms of Greece's bailout and by a regional election defeat suffered by Angela Merkel's Christian Democrat party at the weekend. With public opinion in Germany strongly against Berlin bankrolling any future eurozone rescue packages, interest rates on both Italian and Spanish bonds rose to their highest level in a month.

The hunt for safe havens sent the price of gold above $1,900 an ounce while 10-year bond yields in Germany dropped to record lows of 1.83% at one point.

Reports from Berlin quoted Merkel as saying that the situation in Greece and Italy was "extremely fragile", echoing comments from Christine Lagarde, the managing director of the IMF. The former French finance minister warned that the global economy was on the brink of a new crisis.

"We see that there has been, particularly over the summer, a clear crisis of confidence that has seriously aggravated the situation," Lagarde told Germany's Der Spiegel. "Measures need to be taken to ensure that this vicious circle is broken."

Lagarde warned that Europe's banks needed to be recapitalised, to give them protection from losses on their reserves of sovereign debt. She also argued that Europe needed to implement closer fiscal union and speed up its economic growth – which has almost ground to a halt. "The sovereign debt issue weighs on the confidence that market players have in European banks," Lagarde said.

A survey of purchasing managers from across Europe showed activity in the service sector declining modestly, with the fifth successive fall taking the index close to the point where output would be contracting rather than expanding. All eurozone countries experienced a slowdown last month with the exception of France. Germany saw growth in service sector activity drop to its lowest in almost two years, while Spain saw business contract at the fastest rate since late 2009.

Jamie Dannhauser, analyst at Lombard Street Research, said the PMI data was consistent with Spain and Italy going back into recession, adding that the loss of momentum for the eurozone should be a serious concern for the European Central Bank, which has twice raised interest rates this year after becoming alarmed at rising inflation. "An ECB policy shift may not be far away," Dannhauser said.

Despite the release of figures showing that the ECB stepped up its purchase of Italian and Spanish bonds last week in an attempt to keep interest rates low, Italian 10-year yields rose to 5.58%, their highest since 8 August. Heavy bond purchases by the ECB helped drive down borrowing costs in Spain and Italy from just over 6% to 5%, but market interest rates have been creeping up again in recent days amid concerns that Europe lacks a comprehensive plan to deal with the sovereign debt problems in the weaker countries of the eurozone. Germany's constitutional court will announce its decision on Wednesday on the legality of the eurozone bailouts, following several challenges against the rescue packages for Greece, Portugal and Ireland.

Tom Stevenson, investment director at Fidelity International, said: "After a period in which bad news was taken by the market as good news (because it was perceived to increase the likelihood of further monetary stimulus) disappointing announcements have in the past couple of days started to weigh on sentiment again. Investors have judged that the US Federal Reserve is less inclined to ride to the markets' rescue than it was a year ago when it launched the second round of quantitative easing."